Deciphering the Liquidity and Credit Crunch 2007-2008

The financial crisis in 2007 and 2008 specifically experienced two severe circumstances. On the one hand, the banks wrote down several hundred billion dollars bad loan caused by mortgage delinquencies, driven by the bursting housing bubble. On the other hand, the stock market of major banks fell dramatically. Both circumstances damaged the real economy severely. There are two key factors leading up to the housing bubble. First, the interest rate in U.S. was low because of foreign capital inflows and the lax interest rate policy adopted by the Federal Reserve. Meanwhile, the banking system applied an 'originate and distribute' model, rather than traditional model, in which the issuing banks hold loans on their balance sheets until repayment is made.

Two trends in the banking industry significantly had contributed to the lending boom and housing bubble that laid the bottom for the crisis. Firstly, the 'originate and distribute' model enabled the bank to repackage loans and pass them on to other financial investors, together with the risk. Secondly, banks used more and more shorter financing, leading to liquidity squeeze.

When move to the 'originate and distribute' model, banks create 'structured' products to reduce risk. These products are referred as collateralized debt obligations (CDO). The bank at first groups various mortgages and other types of loans, corporate bonds and other assets together to form diversified portfolios. Then these portfolios are divided into different tranches. These tranches are sold to invest groups with different attitude towards risk. The safest tranche provides a low interest rate while it's the first to be paid. Each tranche will receive a rating to demonstrate its riskiness. Usually, the issuing bank will hold the least safe tranche. Another kind of product, credit default swap (CDS), is created to offer protection to buyers of tranches. Such buyers can contract with the bank and pay a periodic fixed fee in exchange for contingent payment in the event of credit default. It is believed that, a combination of an AAA-rated tranche and a CDS will actually have low risk since the probability of default of the CDS counterparty is small. One of the advantages of such kind of securitization is that, risk will be delivered to those who wish to bear it and allows for lower interest rate. Moreover, certain institutional investors can hold assets that they were not allowed to hold before by regulation. Besides, other factors also contribute to the rise in popularity of structured investment vehicles, for instance, regulatory and ratings arbitrage. The capital charge for loans required by the Basel I was much lower than that for contractual credit lines. Moving a pool of loans into off-balance-sheet vehicles and granting a credit line to that pool to ensure an AAA-rating, would allow banks to reduce capital to hold under same risk level. For the Basel II, the capital charges are based on asset ratings. At this time, banks can still reduce capital charges by pooling loans in off-balance-sheet vehicles since assets issued by these vehicles received a better rating. Furthermore, the statistical models provided overoptimistic forecasts about structured finance. Besides, structured finance products may receive more favorable ratings compared to corporate bonds because rating agencies charged higher fees for structured products and 'rating at the edge' may occur. To conclude, as a result of the rise in popularity of securitized products, the volume of cheap credit increased greatly and lending standards fell.

The second trend is that banks increasingly financed their asset holdings with shorter maturity instruments. The shadow banking system bears maturity mismatch as traditional banking has. The structured investment vehicles raise funds by selling short-run asset backed commercial paper and medium-term notes. Banks would face funding liquidity risk by taking this strategy although the bank grants liquidity backstops to these vehicles. Moreover, banks growingly financed with short-term repurchase agreements (repos). Such maturity mismatch mentioned above would reduce funding liquidity and hence bring significant stress to the financial system.

The liquidity crisis that mainly caused by increasing subprime mortgage defaults was firstly recognized in spring 2007. The ABX index, based on the price of credit default swaps, dropped considerably, leading to raising cost. Rating downgrades came to unnerve the market, and some hedge funds imploded. In July 2007, the concern about structure finance products valuation and decreasing confidence in the reliability of ratings affected short-term asset-backed commercial paper market. IKB and American Home Mortgage Investment Corp. announced their inability to fund lending obligations. The money market participant became reluctant to lend, causing a jump in interest rate. Meanwhile, the LIBOR rate rose because of higher interest charged for unsecured loans, and the TED spread widened. From August 2007, the illiquidity began to affect interbank market. The significantly increased perceived default and liquidity risks of banks drove the LIBOR up. The European Central Bank and the Fed made injections into the interbank market. Also, the Fed reduced the discount rate, broadened the type of collateral that banks could post and lengthened the lending horizon. However, banks were always reluctant to borrow from the discount window since they considered this as a signal of lack of credit-worthiness. The Fed lowered the federal funds rate then. During fall 2007, a series of write-downs happened and the forecast of $200 billion loss was revised upward. The TED spread widened further, driving the Fed to cut the federal funds rate further. In December 2007, the Fed announced the creation of the Term Auction Facility, which provided banks 28-day loans. The 'monoline insurers', which emphasized completely on one product, also suffered. When the monoline insurers were downgraded, a great loss on AAA-insurance for hundreds of bonds and structured products was caused. This fact consequently made a sweeping rating downgrade across financial instruments and a huge sell-off of assets. Besides, the US equity market experienced a large drop and led the federal fund rate to be cut again. The government-sponsored enterprises cannot escape from this crisis. The interest rate spread between agency bonds of Fannie Mae and Freddie Mac, and Treasury bonds widened again by mid-June 2008. As condition became worse, the Treasury Secretary had to announce plans to make implicit government guarantee explicit. The overall stock market lost about $8 trillion in the year after October 2007. Wall Street's problems seemed to spill over to Main Street. The global economy was infected a lot and a proactive, coordinated action